Warnings of Nascent Inflation as the Market is Poised for New Recovery Highs

The stock market posted broad based gains last week, with defensive sectors up 2 – 3% and most growth oriented sectors up 5 – 7%. The exceptions were Energy at 8% and Metals & Mining at 11%. The performance of these latter two sectors speaks to underlying inflation concerns as the world returns to growth.

Although volume was lighter on the week we don’t view this as a problem, especially on the NASDAQ. Distribution has been light and NASDAQ volume was above average for the week. Even on the S&P 500 where volume was below average the power of price has been impressive.

The market is set up to move to new highs (indeed the Dow has already achieved fresh recovery highs) on anything it interprets as good news on earnings reports. It is likely to take significant disappointment to derail it. Bear in mind we refer to what impresses the market. Traders have been looking for weakness in the market for seven months now and have to avoid putting their own biases on it. If raised guidance by, for example, an Intel doesn’t impress you but the market moves materially higher, we suggest your trading will be far more successful if you respect the market’s judgment and trade with its trend.

We note some interesting developments in bonds. After aggressive rallies off the March lows money has begun to come out of investment grade corporates (using the ETF LQD as a proxy). The rally has been less impressive in municipals (MUB – not shown) but it seems to be experiencing distribution as well. Meantime junk bonds (HYG), while having suffered some corrective action have recovered well. This occurs while interest rates on treasuries at the longer end of the yield curve have begun to move higher ($FVX, $TNX shown, $TYX).




Treasury rates staged an impressive rally off the March bottom but have been consistently easing since June. Last week they turned aggressively off their lows but remain well off their highs. We cannot conclude by their charts that they will return to their highs soon. But the overall pieces of the puzzle suggest, with the increasingly likely passing of a more costly health care bill than expected and indications that there will be further fiscal spending (stimulus) by the administration, that interest rates on longer term Treasuries are likely to go higher over time.

With money coming out of lower yielding instruments we don’t view this as anything other than an interest rate play as corporate junk bonds (HYG) continue to hold up, negating any interpretation that this move could be a flight to quality, where money seeks shelter from risk.

While these trends are far from confirmed and are simply casual observances at this point, rising rates on longer term treasuries as a reflection of inflationary expectations coupled with an expected low growth recovery could be an early harbinger of a return to 1970’s style stagflation.